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Barron's Feature

Are We Headed For a New Age?

By

Jonathan R. Laing

Updated Jan. 11, 1999 12:01 a.m. ET

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A re we about to enter a decades-long period of rising purchasing power, mind-boggling technological breakthroughs and increasing social harmony? Numerous signs suggest that we are, much as the world did during the Industrial Revolution in the 1800s, the Renaissance in the 1400s and the Enlightenment in the 1700s.

The frequent precursor of such eras of good feeling has been the end of a period in which consumer prices have been rapidly climbing and the beginning of a period in which consumer prices fall or at least stabilize. Recent evidence of slowing inflation, however, has been greeted with some alarm by some Wall Street economists. They worry that falling commodity prices and a flood of cheap Asian imports will push America into a deflationary spiral in which ever-lower prices will roil the world's economies.

But declining prices aren't necessarily bad. History tells us that protracted periods of falling and stable prices can be beneficial for consumers and for businesses alike. It should be pointed out, of course, that prices of all goods and services aren't declining right now, nor can they be said to be absolutely stable. Today, the Consumer Price Index is still showing an annual gain of about 1.5% here in the U.S. Still, prices are far more tame than they were in the 1970s, 1980s and early 1990s. And the prices of key commodities such as crude oil, copper and hogs are sinking to their lowest levels in decades. To many experts, the trend toward deflation seems inexorable.

The great fear, of course, is that if prices in general slide over the next year or two, they could trigger an economic depression of the sort the U.S. experienced in the 1930s. Such fears have been heightened by Asia's moribund economies. Indonesia, for one, is now facing famine, pestilence and anarchy.

Investors' hysteria over deflation is somewhat amusing to economist and forecaster A. Gary Shilling, Ph.D. Since the late 1970s, he has been pounding the table to warn of a major slowdown in inflation. About five years ago, he first began forecasting a sustained decline in consumer prices. Shilling earned much media attention in 1989 when he created a board game based on Monopoly, called The Deflation Game. And earlier this year, he published a 372-page monograph called Deflation, which laid out the business, economic and investment implications of mild annual declines in the prices Americans pay for goods and services.

Perhaps of greater moment, he maintains that there is little to fear from deflation. In fact, his studies of economic history show deflation to be a largely benign phenomenon that has accompanied some of the most glorious periods of economic growth in America. One such era was the final four decades of the 1800s. Another was the 1920s.

"It's only because of the Great Depression, with its nightmarish images of soup lines, shantytowns and 25% unemployment that deflation inspires such hysteria among Americans," he observed in a recent interview in his memento-filled office in the New Jersey suburb of Springfield. "More often than not, though, deflationary periods have proved to be wonderful times to be alive for the average American in terms of productivity-enhancing technological innovation, rising real wages and, of course, strong economic expansion."

Such benign deflation occurs because supplies of goods and services are growing faster than demand. This leads to lower prices as vendors try to clear their shelves. So, even though the average American's wages may flatten or even fall during such a period of deflation, his purchasing power, his real wealth, rises because prices are falling faster than his income. Likewise, in Shilling's ideal scenario, jobs remain plentiful because low prices drive up sales volumes, revenues and profits, particularly in industries that benefit from technological advances.

Between 1860 and 1896, for example, the number of U.S. workers employed in manufacturing and construction tripled, and manufacturing output measured in units rose sixfold. Because of this cornucopia of supply, the wholesale price index fell some 50%, or 2.6% annually, during the period. Yet real economic growth rose an average of 4.3% a year as a result of soaring volumes, huge productivity gains and immigration-fed population growth. Workers' purchasing power rose nearly 30% despite a 14% drop in wages.

The major wellspring of this bounty, of course, was America's Industrial Revolution. Production costs were driven relentlessly lower by new technologies such as the Bessemer steel process, the power loom, the steam turbine, the linotype, the acetylene torch, roller grinder flour mills, arc welding and electric motors. Agricultural and metal prices plummeted as the rapid build-out of the intercontinental railway system opened the land and mining resources of the West to exploitation. The mechanical reaper, followed in 1890 by invention of the combine, dramatically boosted America's agrarian productivity.

Although falling grain prices drove some American farmers into bankruptcy, the plummeting cost of farm machinery and transportation during the era helped cushion hard times for many efficient operators. And the U.S. farmer in the Western states fared far better in the global market than his less-productive counterparts in Britain, France or Prussia.

Likewise, Shilling points out, Americans during the 1920s benefited from surging production of automobiles, electric appliances, home furnishings and radios. This consumer bonanza resulted in large part from the rapid electrification of factory equipment and the revolutionary production techniques perfected by the likes of Henry Ford. Wholesale prices dropped some 5% for the decade, while industrial production doubled and real incomes rose some 40%.

According to Shilling, a similar golden era of deflationary growth is upon us. The reasons are diverse. For one, the end of the Cold War has allowed governments, particularly in developed nations, to cut wasteful, inflation-inducing spending on defense. This, combined with voter disgust with inflationary spending by politicians, is causing government spending growth and budget deficits to shrink and, in the case of the U.S., budget deficits are turning into surpluses.

At the same time, government deregulation in the U.S. and in other developed nations has removed all manner of price floors that previously served to institutionalize inflation by creating what economist Robert Heilbroner once described as "floors without ceilings." As Shilling explains, "Beginning some 20 years ago, the U.S. government has allowed the bracing winds of competition to lower airline fares, trucking rates, natural-gas prices, electrical rates and long-distance and local telephone charges. And that doesn't even take into account the new cost efficiencies being achieved in financial services as a result of the removal of state restrictions on bank branches and traditional strictures that kept banks, brokerage houses and insurance companies from poaching on one another's markets."

Then, too, there is the aging of the populations in the U.S. and other developed nations. This implies some slowdown in consumption spending after years of torrid growth during the time when the postwar Baby Boomers were forming families, buying houses and so forth. These Baby Boomers will have little choice but to cut back their spending in the years ahead if they want a secure retirement. In September and October, the U.S. had a negative savings rate, the latest evidence that consumers have maxed out on their credit cards, drained off much of their remaining home equity and created a dangerous dependence on stock-market gains, which could prove evanescent.

Yet another deflationary factor is the surge in corporate restructuring. Kicked off by the U.S. in the 1980s, the restructuring trend now seems a permanent feature for businesses in both the U.S. and Europe. Flattening organization structures, cost-saving, outsourcing, pay-for-performance and the refining of work processes are never-ending activities that continuously cut costs and spur enhanced productivity. "Gone are the days when companies could make temporary cuts in travel, entertainment and advertising during a recession and reverse them all when times got better," Shilling contends. "Nowadays companies have to be in a permanent cost-cutting mode."

Technological advances are also fueling deflation by cutting costs and boosting productivity. High-tech spending on its face still appears to be a trivial part of the total U.S. economy, accounting for perhaps 7% of annual economic output. But Shilling claims that high-tech's share of the economy is dramatically understated. The 7% doesn't include such items as semiconductors in cars, appliances or industrial control systems, nor does it embrace genetically enhanced seeds or all the spending devoted to software. The latter is considered an operating cost rather than a capital investment.

The deflationary impact of technology extends far beyond the constant declines in computer prices, memory chips and micro-processors. Technology enhances the efficiency and reduces the operating costs of almost any activity, from telecommunications to electricity generation to oil prospecting to financial services to retailing.

Most obvious, perhaps, is the deflationary impact the Internet is having on business. First, the 'Net just about eliminates the cost of comparing the prices of cars, life insurance, airline tickets, books or new winter coats. Whole layers of middlemen and showrooms disappear in this virtual marketplace. The resulting savings can mean lower prices for consumers at the same time that they mean higher profits for manufacturers.

Another profoundly deflationary factor at work today has been the opening of the world to the free flow of capital as a result of the triumph of free market principles, the advent of modern telecommunications, deep tariff cuts and relaxation in capital controls. As a result, U.S. corporations and other multinationals are relatively free to search out the cheapest labor, real estate, productive capacity and support services, whether that means computer programmers in India, insurance-claims processors in Ireland or maquiladora manufacturing plants in Mexico.

In the end, this shift to low-cost providers has proved to be a more important byproduct of globalization than the oft-touted expansion of markets for U.S. goods, according to Shilling. The real news here is that the U.S. and other advanced nations have been able to export the Industrial and Information Revolutions to the less-developed world, while importing the low-cost fruit of these efforts.

The Asian economic crisis is intensifying this gathering force of deflation by creating a glut of unused industrial capacity, raw materials and manufactured products. Indeed, commodity prices like those for oil and copper have crashed not only because of reduced worldwide demand but also because developing nations are hard pressed to boost their exports so they can pay for their imports and keep as many jobs as possible. In fact, many developing nations have some incentive to operate at a loss and boost commodity production all the more as prices fall, Shilling maintains. Their need for foreign currency has become that dire.

Yet Shilling isn't overly worried that the economic woes of Asia, Russia and Latin America will unduly threaten the U.S. and other advanced nations with a descent into the vortex of 'Thirties-style depression. Deflation turned lethal in the Great Depression only because of a confluence of unusual circumstances. Then a financial collapse in stocks and, subsequently, in the banking system happened to coincide perversely with the normal forces that trigger deflation: excess capacity and a slowdown in technological advancement. Together, these factors caused an implosion in demand and heavy job losses. A collapse in consumers' purchasing power ensued.

Any such repeat of the 'Thirties experience is unlikely today, Shilling claims. Rolling recessions and adjustments over the past 10 to 15 years have purged the U.S. of many of the financial excesses that plagued the nation in the 1980s. Federal bailouts a decade ago helped the farm sector and oil patch survive the collapse in commodity prices. The savings-and-loan industry was likewise rescued at great taxpayer expense. Subsequently, the Fed engineered a dramatic drop in short-term interest rates in the early 1990s to help the U.S. banking system rebuild its capital base following a bust in loans for real-estate development and leveraged buyouts. And in recent months, central banks in the U.S. and Europe engaged in a series of coordinated interest-rate cuts to calm international financial markets following a crisis triggered by Russia's debt default last August.

Lastly, the U.S. is running a budget surplus, corporate balance sheets remain strong, and developed countries' exposure to troubled Asian markets is manageable, if not inconsequential. All in all, Shilling figures, we are not dealing with the fodder for a full-bore depression.

Yet Shilling isn't an unabashed bull over the short term. That would be asking a lot from the 61-year-old economist, who has spent much of his three-decade career on Wall Street with stops at Merrill Lynch and White Weld before founding his own firm in 1978. He has forecast recessions every few years, and more than a few of these calls have been wrong. He clearly is a card-carrying member of the "no pain-no gain" school -- literally. He has spent much of his free time since 1990 tending honeybees and suffers hundreds of bee-stings a year in pursuit of that hobby.

Shilling expects a tough transition period to occur before the deflationary Golden Age ensues. This could include an imminent slide in stock prices of 40%-50%, followed by a consumer savings spree and a nasty recession. "Such a scenario wouldn't be the end of the world, but given the current psychosis over deflation and depression, a lot of folks will see a repeat of the 'Thirties coming," he avers.

His near-term bearishness reflects his concern about current market prices. He claims that stock ratios, whether they measure price-to-earnings, price-to-book or price-to-cash flow levels, are at unsustainable heights. Moreover, Shilling worries about investors' wildly inflated expectations of stock-market returns. He points out that U.S. corporate profits are likely to suffer over the near term from weakening exports, savage competition from Asian imports, unfavorable foreign-currency translations and tight labor markets.

He expects U.S. shareholders to cut and run before long, dumping stocks at the first sign of serious trouble in the stock market. "The bulk of retirement money in the market today is in defined-contribution plans, which investors control themselves. This will prove to be hot money that will head for the exits during the first sustained stock-market downturn, because the Baby Boomers are so invested in the market and have saved so little for their retirement," he maintains.

Shilling, of course, isn't the only deflationist on Wall Street these days. Back in 1995 when doom and gloom over America's tepid "jobless recovery" held sway, economist Maureen F. Allyn of Scudder Kemper penned a prophetic report on a brave new world she saw emerging that would be characterized by falling price levels, healthy growth, more and better U.S. jobs, sharply rising living standards and strong financial-asset markets.

Even she has been astonished at how quickly these roseate forecasts have come to pass. Nowadays, she shares some of Shilling's concerns. Benevolent deflation comes, of course, from growth-enhancing characteristics like innovation, deregulation, efficient capital flows and expansion of supply. Yet deflation's evil twin can destroy growth by blighting the very demand that lower prices are supposed to stimulate. Such a scenario has unfolded in Asia, where imprudent lending and excessive money growth have led to skyrocketing loan losses, collapsing asset values, wealth extinguishment, an obdurate credit crunch and a deflationary recession, perhaps even a depression.

While Allyn thinks it unlikely that such bad times will reach U.S. shores, she doesn't totally dismiss the possibility. The Fed's easy money policies of late may have helped create an unsustainable stock-market bubble. Despite the basic soundness of the U.S. banking system, she worries about excesses cropping up in other credit arenas such as the asset-backed lending and junk-bond markets. "I'm most likely overreacting and arguing with myself, but I don't like the build-up I'm seeing in household debt leverage," she said in a telephone interview. "Yet over the long haul, my money is still on the good deflationary scenario."

Deutsche Bank Securities economist Edward Yardeni has been a deflationist and New Era bull since the 'Eighties. But now he, too, has begun to sound notes of caution about the near-term outlook for the U.S. stock market and economy. He expects a market slide of 30% or more, followed by a recession sometime in 1999. After that, he predicts, the U.S. will reach the Promised Land of non-inflationary growth.

Deflation has its risks, according to Yardeni. For example, it doesn't take much for a deflationary psychology to develop that can turn lethal. Consumers can get accustomed to delaying purchases of goods and services in anticipation of even lower prices, and that does serious damage to producers as inventories swell and revenues fall. Such a cycle tends to feed on itself, forcing companies to react by laying off workers and chopping capital spending. This, of course, crimps purchasing power and ultimately lays waste to demand.

Most prone to such a meltdown are older, low-tech industries like metals, paper, steel and even automobiles. Unlike the computer and telecommunications outfits, these traditional industries have little experience with constant price-cutting over a product cycle. Nor are traditional industries as experienced at making constant innovations in their product lines to force obsolescence, drive unit sales and boost revenues and earnings.

Yardeni, a confirmed cybernaut, sees a possible menace in the Internet and online commerce. He ruminated in a recent report that the 'Net might be so successful in forcing producers of goods and providers of services to pare their profit margins that employment and capital spending might suffer in the process. "While consumers win as consumers [on the 'Net], they could lose as employees of companies that cannot compete in cyberspace," he concluded gloomily.

Poppycock, says James Paulsen, an economist at Norwest Investment Management, in Minneapolis. He insists the U.S. is in the early stages of what he has taken to calling a "deflationary boom," fueled by a technology leap comparable to the Industrial Revolution. He also points to the salubrious effect of falling interest rates and sliding commodity prices. To keep the party going, though, consumers' purchasing power and corporate profits must keep growing. Paulsen is quite optimistic on that score, however.

As a result, he's an ardent bull on both bond and stock prices, even given the latter's sharp rebound since last fall and today's sky-high levels. By his reckoning, the bear market washout in stocks already occurred in October, and the investment theme is now onward and upward.

In fact, Paulsen claims that stocks suffered their worst postwar decline relative to bonds between June and November of last year. Though blue-chip stocks fell by only a bit more than 15% during the period, they effectively declined around 40% relative to bonds. In contrast, stocks fell only about 20% relative to bonds during the bloody 1973-74 bear market, he says.

Rarely do scholarly works shed much light on burning contemporary issues like deflation and its likely impact on the global economy. Many academics are loath to make predictions. They likewise have a tendency to get buried in empirical minutiae.

Happily, this isn't the case with the weighty 1996 book The Great Wave, by Brandeis historian David Hackett Fischer. The tome seeks nothing less than to trace the waxing and waning of inflation in Western history from the 12th century to the present. It's a work of prodigious scholarship with more than 200 pages of footnotes and appendices and chart data on everything from land rents in 15th-century Normandy to two centuries of rye prices in Frankfurt to illegitimate-birth trends in Victorian England.

What gives the book particular relevance today is its description of the structure of periods of relative price stability, or what Fischer calls eras of "price equilibrium," which inevitably follow the long spasms of inflation that punctuate some 800 years of Western history. So far, there have been three such equilibrium periods, according to Fischer, averaging some 70-80 years in length. The first ran from 1400 to 1480, the Renaissance; the second from 1660 to 1730, the Enlightenment Era, and the third from 1830 to nearly 1900, the Victorian Age.

What distinguishes these equilibrium periods from the hyper-inflationary eras that immediately preceded them was the sharp improvement in the economic fortunes of a broad range of the population that benefited from sharp declines in the costs of food, shelter, land rents and interest rates. Manufactured goods typically decline in price, too, but for the most part that occurs late in the equilibrium periods. About the only groups that fare worse during equilibrium periods are producers of commodities and basic materials and the upper-crust rentier class. Rents and interest rates typically fall during periods of price stability.

These deflationary eras were also times of rising real income and positive increases in real economic output. Moreover, income inequality tended to diminish as the periods wore on. Nations became less prone to engage in bloody foreign wars. An amelioration in social mood led to falling rates of illegitimacy, alcohol and drug consumption and crime. Lastly, according to Fischer, these periods were marked by increased faith in harmony, order, progress and reason. This came in sharp contrast to the cynicism and nihilism that typically obtained at the end of long inflationary waves.

Even though prices have been disinflating for more than a decade in the U.S. and other Western nations, and crime rates have been in sharp decline, Fischer insists in the book that the great 20th century inflation wave had still not run its course. Of course, a certain pessimist chic still reigned a few years ago when he wrote the book. Fischer also claimed not to have yet seen a cataclysmic event comparable to the Black Death in the 14th century or the Napoleonic Wars in the early 1800s, which marked an end to those two prior inflationary waves.

But Fischer appeared to have changed his point of view on that score when we recently reached him by telephone at his home in Wayland, Massachusetts. "As much as I've always avoided prophecy, indications like falling crime rates and recent rises in real income seem to indicate that we may be on the cusp of yet another equilibrium period," he opined. He concedes that, among other things, he may have misread the import of the "collapse of the totalitarian system of the left [meaning Eastern Europe and the Soviet Union] and the right [Latin America]" as events that could herald the end of this century's inflationary wave events.

What exactly triggers deflation and then sustains the long periods of price equilibrium remains something of a mystery to Fischer. Declines in population growth seem to play a role, along with a muting of standard-of-living expectations. Obviously, governments, after decades of traumatic inflation, are more inclined to exercise a modicum of fiscal and monetary discipline. Lucky occurrences like a string of strong harvests seem to have played a role historically. Or maybe there have been random factors at work unique to each period.

Another explanation comes from Chicago-based consultant and futurist Lewis Larsen, who graced the pages of Barron's more than a decade ago with a dead-on prediction that a coming technology revolution would vault the U.S. decisively ahead of the Japanese in international economic competitiveness. In Larsen's view, bursts in technological innovation, with all their attendant productivity gains, are the crucial factors these days in bringing on periods of price equilibrium.

He describes the process: Inflationary waves, particularly in their late virulent stages, force economic substitutions through technological change. But only when disinflation begins and interest rates come down can many of these ideas attract the financing necessary to achieve critical mass. Then a self-reinforcing process sets in. Innovation brings down prices and interest rates, allowing more investment which, in turn, lowers costs and increases efficiency even more. And so on.

Larsen cites statistics on some 200 years of U.S. patent grants to bolster his argument. Patent activity skyrocketed after 1820 to double the level of the first two decades of the century. Later on, that era of equilibrium benefited from quantum leaps in patent activity in the 1860s and again in the 1880s after the effects of the 1873 bank panic wore off. And today, we're in the early stages of yet another burst in patent activity, according to Larsen, which augurs well for increased productivity gains. Last year, some 112,000 patents were granted, compared with 66,000 in 1981, when inflation was cresting.

On top of that, recent technological changes have played a major if unpublicized role in the collapse in crude oil prices, says Larsen. Among the key developments are recent advances in the direct conversion of cheap natural gas to synthetic crude oil, plus the use of embedded microprocessors and software to control the energy consumption in large buildings, plants and equipment. An example of the latter are new chips that will cut the power used by electronic components and computers in the "standby" mode by more than 95%. And this doesn't even take into account huge energy-saving breakthroughs that Larsen expects in the realm of automobiles powered by hydrogen fuel cells and the possible commercialization of power-generation techniques such as cold fusion.

Of course, much of this lies in the future. But that's the point. The future may well be brighter than most commentators believe. In fact, with the slaying of inflation, history suggests we are on the verge of a new Golden Age that will last many decades.

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